Book Review: The Little Book of Big Profits from Small Stocks

The Little Books series has produced several memorable titles, such as Joel Greenblatt’s The Little Book that Beats the Market.

Greenblatt offers a mechanical investing strategy that involves very little work on the part of the reader. You simply build a portfolio of 30 stocks from his screener and rerun his “Magic Formula” screen on an annual basis.

Hilary Kramer’s The Little Book of Big Profits from Small Stocks[1] is not that kind of book. Kramer does not offer a trading strategy or a proprietary screener. Instead, she teaches her readers how to think for themselves.

Kramer, a Wall Street veteran, has carved a niche for herself in an area where most professional money managers are afraid to tread: low-priced stocks trading for less than $10 per share.

As Kramer points out, most mutual fund managers and other institutional investors could not buy low-priced stocks like these even if they wanted to; their investment mandates forbid it.

But even if they have the ability, few have the intestinal fortitude. Their own research departments generally won’t cover the stocks, and it’s a career risk to buy a stock that is too far out of the mainstream. As the old saying goes, “no one ever got fired for buying IBM (NYSE:IBM[2]).” But if a manager bets big on a smaller company that ends up going bust, they might be out of a job.

Not all low-priced stocks are good buys, of course. As Kramer writes, “Many stocks under $10 are cheap because they deserve to be. They are dogs that never had potential, were permanently damaged by the recession, or have misstepped so badly they have no hope of ever getting back on track.”

Still, there are potential gems for those investors willing to do the research and look. “Breakout” stocks are usually buried among other low-priced losers. Due to the mechanics of the market, it’s generally a lot easier for a $5 stock to go to $10 than for a $50 to go to $100. Yes, the percentages are the same. But lower-priced stocks tend to be low-capitalization stocks as well.

A large-institutional investor like Warren Buffett moving into a small-cap stock is going to move the price a lot more that he would in a large, liquid stock with an enormous float. The key is finding these gems before the big boys do.

Kramer notes that low-priced stocks are a great place to find fallen angels, or large (formerly) blue-chip companies that have fallen out of favor for various reasons, such as missing an overly optimistic earnings forecast or lack of direction from management. In looking for a fallen angel, you have to ask two questions: What went wrong? And can it be fixed?

Kramer gives the example of Ford (NYSE:F[3]), a stock that she bought during the pits of the 2008-09 crisis. It’s pretty easy to see what went wrong with Ford. Its product line had gotten stale, it owned too many non-core brands, it had too much debt, and it had obligations to the United Auto Workers it could never hope to honor.

But could these be fixed? In the short term, yes. Ford revamped its lineup, sold off some of its non-core brands, and restructured some of its debts and union obligations. Oh, and in the process, Kramer’s investment soared from $2 per share to $18 two years later.

You cannot do a screen for fallen angels and buy them as a group. Instead, you have to examine each on a case-by-case basis and make a judgment call. There are, alas, no shortcuts.

All large companies start small, and low-priced stocks are often a good place to find up-and-coming growth stocks. Oftentimes, these are going to be companies in non-sexy industries, such as junkyards or waste collection. Though Warren Buffett usually buys larger companies, some of his outsized returns over the years have been due to his willingness to buy companies in “boring,” unglamorous industries.

Finally, low-priced stocks are a great place to find companies in the “good old bargain bin,” or companies selling for less than their book value.

Kramer identifies two sectors in particular that tend to be good hunting grounds for low-priced stocks. I would advise caution in exploring the first sector: medical and biotech stocks.

Biotech stocks often have binary outcomes. They produce a new “it” drug and enjoy returns of hundreds or thousands of percent — or they don’t, and they end up going bust. Still, if medical technology is an area of expertise for you, it might be worth your while to give these stocks some attention.

Kramer’s other hunting ground is one that I am a fan of — emerging markets. With Europe, Japan and the United States all mired in long-term debt and demographic problems, emerging markets will be some of the few reliable sources of growth in the years ahead.

But here too, you need to be careful. What makes these stocks potentially attractive is that they are not widely covered by Wall Street. But part of the reason they are not covered is that they don’t have much in the way of public reporting, and what they do have may or may not be in English.

Plus, you might have a hard time buying them. Many do not trade in the U.S., or they trade on the “over the counter” markets, which tend to be thinly traded. So, you’ll need a broker that will give access to foreign exchanges.

A low-priced investment strategy is a value approach of sorts, but it is different from the sort of value approach that many investors are used to taking. For example, Kramer maintains that the price/earnings ratio, which is a basic metric known to all value investors, is generally not applicable to the low-priced stocks she covers:

“We are looking for signs of improvement and plans to continue or return to a growth trajectory. For example, the P/E ratio isn’t going to help us pick these kinds of stocks. After all, the P/E ratio requires the current share price and the earnings per share price for a stock. And often low-priced stocks have little to no earnings at the time they are poised to become breakout stocks, or show earnings that are cyclically depressed”

As a case in point, Ford had P/E ratio of 88 when Kramer bought it because its earnings had been gutted in the crisis. You don’t really care what the earnings were yesterday; you want to estimate what they will be tomorrow.

There is a lot of investing wisdom in the pages of Big Profits from Small Stocks, and Kramer has chosen her hunting grounds well. I don’t always pay attention to academic work in finance because a lot of it is nothing more than a very sophisticated way of stating the obvious.

But there was one 1992 landmark paper by Eugene Fama and Kenneth French titled “The Cross Section of Expected Stock Returns” that basically proved that value investing and small-cap investing outperform over time. Kramer’s low-priced stock approach is really a small-cap value strategy.

In any event, Kramer’s approach will work best during or immediately following a crisis, when the market is full of fallen angels that were the proverbial baby thrown out with the bathwater. During times of relative market calm — such as today — there are simply going to be fewer opportunities, and the ones that are out there will require more research to find.

I recommend you keep Kramer’s book on your shelf and give it a read next time we get a good market selloff.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. Click here[4] to receive his FREE 8-part investing series that will not only show you which sectors will soar but also which stocks will deliver the highest returns. The series starts November 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.

Endnotes:

The Little Book of Big Profits from Small Stocks: http://www.amazon.com/gp/product/1118150058/ref=as_li_ss_tl?ie=UTF8&camp=1789&creative=390957&creativeASIN=1118150058&linkCode=as2&tag=marcombychale-20